Scandals involving artificially inflated corporate incomes have been in the news heavily in the last few years. In this chapter, Michael Thomsett explains the concept of "core earnings adjustments" and how it can be applied to prevent these abuses.

This chapter is from the book

A Revised Approach

Imagine going to your bank to apply for a loan and filling out an application on which you include a full year's estimated income as an account receivable. At the same time, you leave out several important liabilities. Even more unthinkable, imagine showing interest, dividend, and capital gains income based on what you think you are going to earn through investments over the next few years.

No self-respecting banker or underwriter would allow you, as an individual, to inflate your income and net worth with such moves. However, corporations inflate their numbers all the time. They include accounts receivable, offset by current income, often based not on the timing of delivery but on orders placed; they leave employee stock option expenses off their income statements; and they report estimated investment income for pension assets (the infamous pro forma income number that has caused such controversy).

Why do corporations get away with such liberal accounting interpretations when the same rules would be preposterous for individuals? One reason is that the rules (more precisely, the guidelines) under the GAAP system allow aggressive interpretations of the numbers on the part of our publicly listed corporations. Many of the traditional rules are under review, and the long, slow process of reform has begun. But it will take years. The GAAP systemas a decentralized collection of opinions, research papers, and general guidelinesdoes not reside in any one place. Rather, it is the combined body of knowledge of the accounting industry, led by the AICPA and FASB, but lacking any real authority to enact change.

The process of cleaning up the problems of GAAP will be slow. The consequences of the flaws in GAAP are glaring. These flaws have enabled many companies to overstate sales and net earnings and even to deceive stockholders through questionable and aggressive accounting decisionswith the blessing of the "independent" auditing processto bolster stock prices and maximize incentive compensation to the CEO and CFO. Conflict of interest among executives and auditing firms led to most of the problems of Enron, WorldCom, and dozens of other publicly listed companies, and even to the sudden and rapid demise of Arthur Andersen.

The solution to the problems of how financial results are reported cannot be simple or quick. We need to depend on the SEC and state securities agencies to enforce the laws on the books, on the exchanges to police listing standards, and on corporate executives themselves to restore ethical practices to the boardroom and in dealings with auditing firms as well as with the public. In other words, fixing this problem is going to involve changes on many levels. Meanwhile, what are analysts, financial planners, and investors supposed to do to (a) protect their interests, (b) ensure reliability in the analyses they perform, and (c) offer advice and recommendations on an informed basis? If the very numbers are inaccurate, how can any form of fundamental analysis have validity?

Key Point: The inaccuracies found in financial reporting require long-term reform. In the meantime, investors and analysts need reliable ways to value companies whose stock they buy and hold. This is where core earnings adjustments become so important.

The solution is found in core earnings adjustments. By definition, core earnings are those earnings derived from the primary, or core, activity of a company. Looking at it from another angle, we can also conclude that core earnings are those earnings that can be expected to contribute to long-term growth. This distinction is at the heart of our discussion. Clearly, we cannot include income from discontinued operations, capital gains, or pro forma investment return in a long-term forecast of an earnings trend. At the same time, we cannot exclude substantial expenses like employee stock options if we are expected to identify the likely permanent long-term growth trend.

Standard & Poor's has begun using a calculation of core earnings to modify its corporate bond rating system. This is a significant change from previous methodology and, for some of our largest corporations, a chilling one. Many companies have included in their reported earnings a number of noncore items that, if excluded from the S&P bond rating analysis, may reduce ratings from investment grade down to questionable or even high-risk levels. This could affect long-term capitalization as well as immediate working capital; so the decision to make such adjustments is a serious one, and it demonstrates how serious the problem has become. The aggressive accounting policies employed by many companies have greatly inflated growth projections and, as a direct consequence, stock prices as well. Actual reform to GAAP may take many years, but analysts and financial planners need to be able to apply those adjustments to today's numbers in order to compare corporate value in real terms.

Applying the Core Earnings Idea

When you begin to critically review a company as a potential investment, one of the first things you check is the results of operationsrevenues and earnings. Of course, you assume that the numbers themselves are accurate. But what if those numbers are inflated because they include nonoperational or one-time items? What if those numbers exclude significant expenses that, if disclosed, would drastically change your view about that company?

The very way that companies report earnings is flawed. Published income statements should provide you with a dependable roadmap to estimate likely growth and should be limited to only those items that are derived from operations. Under the current rules of GAAP, many nonoperational items are treated improperly; the rules allow these distortions, and you are expected to perform your detailed analysis based on what you are provided in an audited statement.

What does this problem mean to you? Many of the nonoperational items included as income or excluded from operational costs and expenses are material enough that the true profit picture often is far different than what you see. Later in this chapter, we provide some examples. This distortion of the true picture has led to the beginnings of a new but logical idea: companies would better serve their stockholders by reporting their results of operations on the basis of core earnings. Under this ideal, all core earnings items would be included in the report, and all noncore items would be left out. This does not mean that the excluded or noncore items are not valid forms of income or expense, but only that they should not be included in an analysis of long-term growth.

A reasonable premise is that any analysis you perform for the purpose of identifying stocks is more accurate if based on realistic numbers. Returning for the moment to the analogy of a personal loan application, your banker would expect you to provide a realistic summary of your income. If you had recently sold a boat and included the proceeds as "annual income," the loan officer would remove it, knowing that the proceeds are not part of your recurring annual salary. By the same reasoning, adjusting reported results of operations is intended to state corporate results on a realistic basis. Only with this adjustment can you calculate potential growth and compare one company to another. Without making an adjustment to arrive at core earnings, any comparison you make between companies, or from one year to the next for a single company, are likely to be distorted. If two or more companies have had differing noncore experiences during the year, a company-to-company comparison is also flawed. With core earnings adjustments, it becomes possible to make operational comparisons between those companies.

Key Point: There is nothing mysterious about the premise underlying core earnings adjustments. It is the process of restating annual income on a realistic and accurate basis.